Carbon Fee and Dividend Is Not As Simple As It Sounds

The climate crisis is upon us, and the primary cause is clear: carbon in the atmosphere. How are we going to reduce carbon emissions? Appealing to our sense of responsibility to this earth and to future generations just doesn’t seem to be cutting it. In today’s individualistic, short-termist, market-oriented society, we’re going to need to use a market-based mechanism to reduce the use of carbon in our economy. It’s simple: Make carbon increasingly expensive so that people stop using and emitting it!

This is the motivating idea behind a range of carbon-related economic policies, that have been proposed and implemented in various forms across the world. Perhaps the best known such policy in the US is cap and trade, which has been successfully used to regulate sulfur dioxide and nitrogen oxide emissions—the main causes of acid rain. However, a national cap and trade scheme for carbon famously failed to pass through Congress under the Obama administration.

For years, renowned NASA climate scientist James Hansen has been arguing that he has a much better policy known as carbon fee and dividend (CFAD) It’s meant to be simpler to implement than cap-and-trade and to be revenue-neutral for the government, which ought to appeal to conservatives. CFAD legislation has been introduced into Congress a few times, including by Bernie Sanders in 2013, but it has failed to make any progress thus far.

The basic idea sounds quite simple: levy a fee (don’t use the word tax, because it’s politically suicidal) at the point where carbon enters our economy. Those who take coal, natural gas, and oil out of the ground will have to pay a fee based for every ton of carbon contained in those fossil fuels, and this fee will consistently increase year over year. This fee goes straight back to the American people in the form of a flat dividend, similar to the oil dividend received by residents of Alaska. The fee will make goods and services more expensive based on how much carbon they use, thus discouraging carbon-intensive consumption.

CFAD is meant to be simple because it’s easy to tax carbon at the source: coal mines and oil wells are easier to identify and regulate than the innumerable sources of emissions. And it’s progressive because the rich will end up bearing more of the costs than the poor, but everyone receives the same dividend.

However, my brief investigation into CFAD suggests that it’s actually far more complicated to get this policy right than it initially appears. The problem involves the import and export of carbon in its various forms. If we could implement CFAD uniformly across the entire globe, I think CFAD would work out well. But alas, we must deal with an anarchic web of sovereign states in a globalized world. Carbon will cross many borders and change through many forms in its journey from the earth to its final consumption, and that poses serious challenges to a carbon policy that can only be implemented within one state’s territory.

Dealing With Imported and Exported Carbon

If we didn’t deal with imports and exports, then only domestically produced carbon would be come expensive, with the result that domestic production would quickly collapse, but American consumption would shift to foreign imported carbon with relatively little drop in overall consumption. US reserves of oil, coal, and gas may stay in the ground forever (no small feat!), but US fossil fuel consumption, second in the world only to China, would likely continue unabated.

Of course, Hansen and others have anticipated this with a border adjustment. Incoming products would be subject to a tariff based on their carbon content. The proceeds from the tariffs would be distributed to exporters in some manner to compensate for their increased costs, allowing them to stay competitive with other foreign producers and exporters.

This would actually be quite hard to implement in practice, because we import a lot of different goods, and not just barrels of oil and bars of steel. The carbon fee isn’t based on just the amount of carbon within a given item, but on the entire amount of carbon emitted from its production, from beginning to end. That presumably includes transportation and manufacturing energy. How is that to be measured?

Hansen believes that one of the greatest advantages of CFAD over alternatives like cap and trade is that CFAD is “simple and comprehensive,” whereas cap and trade is “political and prone to graft,” eventually leading to a “large government bureaucracy” (Hansen 2019, “Fire on Planet Earth”, p. 16). The issue of imports unfortunately dashes Hansen’s hopes for a simple policy implementation.

Seeing as a strict evaluation of the carbon footprint of every single imported good is practically impossible, the bill put forth by the Citizen’s Climate Lobby, known as H.R. 763, The Energy Innovation and Carbon Dividend Act, addresses the issue by defining a shortlist of “carbon-intensive products” (such as iron, steel, cement, etc.) and only covering these products with the carbon tariff. While this does greatly simplify the calculation of the carbon tariff, it introduces several new problems.

First, it’s unclear how much of America’s imported carbon footprint would be covered by this shortlist of carbon-intensive products. For instance, imported cars would not be subject to any carbon tariff under these rules. I expect that a substantial portion would be left uncovered, thus reducing the comprehensiveness of CFAD.

Second, this policy becomes vulnerable to precisely the kind of political graft that Hansen had hoped to avoid. The shortlist is subject to the discretion of political appointees and thus not only vulnerable to changes to lobbying and changes in administration, but also reintroduces precisely the kind of political risk that makes long-term investment decisions difficult.

Third, a shortlist would also impact manufacturers that use imported carbon-intensive products on the shortlist, but produce and export goods that are not on the shortlist. As a result, they would not receive the refund provided for exporters and thus be at a severe competitive disadvantage to foreign manufacturers. This is not just a matter of minimizing the social and economic impact upon domestic businesses. It also potentially introduces new political hurdles to a CFAD bill, as it could generate opposition from Congresspeople whose constituencies are negatively impacted by the bill.

It seems like we’re stuck with a difficult choice. Whether we cover all trade with a carbon tariff or only a subset, it seems inevitable that politics and bureaucracy are going to play a major role.

What About Other Countries’ Carbon Policies?

Hansen likes the carbon tariff also because he believes that it could be designed to incentivize other countries to implement their own carbon policy. The carbon tariff is reduced by the “foreign cost of carbon”: the carbon fee already levied abroad. So if a country wanted to reduce how much they were paying the US in carbon tariffs, they would need to implement some kind of carbon fee so that they could collect it themselves.

But how would this foreign cost of carbon be computed? It’s not at all easy to calculate this, especially if some foreign country’s policy is not designed a way to make such computations straightforward. Suppose that Coalistan’s carbon policy involves taxing its coal production by the weight of the coal, rather than the carbon content of the coal. Then the cost of carbon of steel, for instance, would depend on the quality of coal used in the coking process. If there were a tax on air conditioners or a subsidy for electric vehicles, should these count toward a decrease in the carbon tariff?

A further complication arises when we note that in today’s globalized economy, supply chains criss-cross through dozens of states in a complex web of manufacturing and trade. The foreign cost of carbon could be split across several different countries, with the correct breakdown and attribution impossible to determine. Was the electricity used in manufacturing generated by domestic coal subjected to a carbon tax, imported gas from a country without any carbon policy, or solar?

I wonder whether we would also need to assess the implementation quality of these carbon taxes abroad. Having lived in India in the last 4 years, I know well that the laws in effect hardly match their implementation on the ground. Around the world, poorer countries with weak states generally struggle to monitor and collect tax from their populations; a carbon tax wouldn’t be an exception. There would also be a clear incentive to falsify the amount of carbon tax already paid in order to reduce the US carbon tariff. Despite US legislation against the import of goods produced by child labor or containing conflict minerals, we know that these practices continue today.

In practice, I suppose we would not just be passively monitoring other countries’ carbon policies and unilaterally deciding on the appropriate carbon tariff. We would end up in direct negotiations with our largest trading partners so that we can be clear and transparent about how our carbon tariffs are being set, and so that they understand our response would be to future changes in their carbon policies. But the point here is that tariffs cannot be set unilaterally lest there be a trade war. A trade war might not be the worst thing for reducing global consumption and long-term transport of goods, but it’s not a democratic, controlled process of degrowth either, and thus would be likely to negatively impact certain communities without their consent.

I am no expert in many of the topics I’ve touched upon here. I don’t have any particular proposal for how to approach these issues. All I want to say is that carbon fee and dividend is not the simple policy solution that James Hansen and others make it out to be. There are many political and economic consequences of this policy that aren’t obvious at first glance, and I hope that CFAD’s proponents are well aware of them. Otherwise, they may find unintended harms and unexpected sources of political opposition which undermine the promise of this bill.